Most entrepreneurs are aware of the financial risks that come with starting a business. After all, they’re usually in the game for the potential long-term financial rewards. And most understand that some risks are necessary to get to that positive outcome. Even so, skilled entrepreneurs usually take steps to ensure that their investments don’t go awry — and getting surety bonds is one way to do that.
Of course, if you’re looking to get your very first business off the ground, you may not know much about this valuable risk mitigation tool. With that in mind, we wanted to talk about what surety bonds are, how they differ from your regular insurance, and how they fit in with the rest of your business plans.
How Are Surety Bonds Different From Regular Insurance?
Many people struggle with distinguishing the concept of surety bonds from the different kinds of insurance a company needs to have. So let’s draw those lines, to begin with.
In essence, surety bonds are a form of credit that protects a company’s clients and business partners from financial harm. Conversely, insurance typically only protects the company itself. If the company sustains damages, the insurer will usually cover its losses by using the insurance premium.
Meanwhile, a surety bond company would use its premium as a guarantee that the principal will fulfil its obligations. So essentially, the company that took out the surety bond would have to pay for failing to provide the goods or services it promised to their customers. The surety company would only step in if the principal fails to meet this obligation in a timely manner.
Despite these differences, many people still have a hard time wrapping their heads around the concept of surety bonds. Then again, many governments take a similar approach to regulating surety bonds and insurance policies. Moreover, many insurance companies also offer surety bonds — though it’s always better to go through a specialised surety.
As an entrepreneur, you should know that the two are, in fact, different. With that in mind, let’s talk about what you’re really getting when you buy surety bonds.
What Are Surety Bonds and How Do They Work?
As we have mentioned, the practice of acquiring surety bonds is a crucial risk mitigation tool. A surety bond is a contract between three parties:
- The principal, the business required to purchase a bond
- The obligee, which is a client, customer, or business partner (in the case of public contracting bids, the obligee would be a governmental entity)
- The surety, a licensed surety company that backs up the bond
In essence, surety bonds should make potential clients or customers more comfortable with doing business with your company. These documents guarantee that a contractor or a company will follow through on their contract by delivering the goods or services they promised within a certain time frame.
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If the principal is not able to fulfil their obligation, bonding ensures that their clients will at least receive financial compensation. On top of that, they guarantee that the principal will operate within certain legal and ethical limits.
In the event a company or contractor fails to deliver on their promises, a customer could file against their surety bond. The company would then be forced to refund the customer’s investment. However, if the business went bankrupt between the signing of the bond and the customer’s claim, the surety would take on the expense instead.
Which Kinds of Businesses Need Surety Bonds?
As you now know, surety bonds are required by an obligee, which is usually the State or Federal government. Without this requirement, many start-ups wouldn’t opt to get a surety bond. After all, hiring a surety company comes at a financial cost many small businesses may not be able to pay.
Still, the government requires businesses operating within certain industries to obtain a surety bond as a part of their licensing process. You should certainly look into getting one if you are starting a business involving:
- Electrical wiring
- Alcohol license holders
- Travel agencies
- Health clubs
- Medical equipment providers
- Notaries public
- Insurance adjusters
- Mortgage brokers
- Freight brokers
- Collection agencies
- Auto dealerships
If you’re still not sure whether your new business needs a surety bond, look into local and state regulations. Those should shed some light on your situation.
How Do You Get a Surety Bond
Before you apply for a surety bond, you might want to figure out exactly what kind you are required to get. The three main types of surety bonds include:
- Contractor or contract bonds, which are legal documents between a contractor and their clients
- License and permit bonds, aka commercial bonds, which guarantee that your company will adhere to state laws and regulations
- Court bonds, which should reduce the financial risks of court proceedings
Once you figure out what kind of bond your new business needs, you’ll have to find a company that can help you get it. As we have previously mentioned, some insurance companies do have surety bond divisions. However, going through a state-licensed business that specialises in surety bonds is usually the better option.
In either case, the application process itself should be fairly simple. The surety would have bond underwriters examine your credit profile, financial history, and prior entrepreneurial experience. Some sureties even require applicants to have up to five times more equity than the bond amount.
After processing that data, the company will offer you a quote and take you through the necessary paperwork. If you only need the basic kind of surety bond, you may even get it as soon as you sign the paperwork and hand over the premium.
The Cost of Surety Bonds
At this point, many people would stop to consider the price of obtaining a surety bond. If it’s only your first or second time starting a business, you may not have much money to spare. Unfortunately, that will probably make your premium higher.
As you can imagine, no surety company would want to back up an applicant with a lack of financial stability. So while regular bond rates tend to be in the 1–3% range, high-risk applicants may have to pay as much as 10% of the bond amount upfront. Ultimately, the premium you get will depend on the surety you go to, the type of bond you need, as well as your financial status.
By now you should have a pretty clear understanding of the basics of surety bonds. While they may not be the first thing that comes to mind when starting a business, they could be integral to the success and survival of your new enterprise. As we discussed, many industries require you to obtain a bond before you can legally operate. Bonds are a strong signal to customers and government agencies that you are able to conduct business in accordance with local regulations and ethics. Ideally, you will never have to use your bond. But without one, you may be out of business.
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